Rectangles - A Consolidation Pattern
“Rectangles are not often referred to as "rectangles." Instead, they are normally called a "trading range" or "consolidation." and that is a far better description of exactly what they are: A definable period of trading during which prices swing between an approximate high and low price level, or range”.
To gain a clear idea of wether rectangles are forming we need at least two weeks of price data, however months or even longer may be applicable. As can be seen from the below chart of Newcrest Mining (NCM) from November 2003 to June 2005, the “rectangle” length can vary over different periods. The NCM price has no decisive direction as the bulls and bears fight for supremacy until the break outs occur.
“Consolidation periods, by definition, assume that the prices will continue in the same direction the market was trading before the consolidation began”. If the particular stock you are looking at entered into a trading range after an upward movement (as in the Newcrest mining (NCM) chart below) then the expectation would be for the price to eventually continue higher. The same is true for the downside. If the stock enters into a rectangle pattern after a downtrend, then the expectation is for the breakout to be to lower prices.
The height of the rectangle is used to measure the size of the break out. Theory suggests that the share price will roughly move to a price level equivalent to the rectangle’s price range when it breaks out. Conceptually, if you measure the rectangle’s price movement of NCM from Point A to Point B, the share price will theoretically move from Point C to Point D, as it did between June and July 2004. Although considered reliable, the pattern is only an indication. Above, the NCM chart graphically details how the share price range from Point 1 to Point 2 did not fit to the theory and find resistance at Point 4.
Rectangles should not be traded until the pattern is resolved one way or the other. Additionally, the upside break out is often followed by the share price retracing somewhere toward the break out level. It is important to note however, that the pattern becomes null and void if the stock closes below the upside break-out level. This would mean that you would need to exit any strategy entered on the basis of the rectangle pattern existing.
